What is Labor Economics?

Labor Economics is the study of the markets for wage labor. Here, the participants of the labor markets are the suppliers of labor that is, workers and the seeker for labor that is firms which are involved production activities in the economy. The study of labor markets aims to understanding the working of the market by looking and interaction of demand and supply and the equilibrium conditions in the labor market.

Labor is the measure of work or productivity of the human beings. It is different from the productivities of other factors of production such as land and labor. The definition of Labor Economics is that it is the branch of economics that specifically deals with the employers and employees, their behavior and responses to changes in the market conditions.

Is Labor Economics a part of Microeconomics or Macroeconomics?

Labor Economics involves both Microeconomics and Macroeconomics. At the microeconomic level, we study the behavior of individual workers or employees and the employers or firms. At the macroeconomic level, we study the implications at the aggregate level and link it to the good market, money market, and foreign trade market.

What is Unemployment? How is it linked to Labor Economics?

One of the main areas of study in Labor Economics is the different types of unemployment existing in the market. Unemployment rate is the proportion of unemployed labor force to the entire labor force. Labor force includes all the adult non-institutionalized civilians who are actively looking for jobs. This means that those who are in jail, in mental institutions or home for the elderly and those who are not on active duty with the armed forces, and children or those below the legal working age, are excluded from the labor force. It also excludes those who are not actively looking for jobs.

Unemployment Rate and Labor Force have a Major Role to play in Labor Economics because it helps us to understand the supply side of labor markets. The labor force constantly changes with the passage of time, new people enter the labor force as they cross the legal age limit, new graduates join the labor force as they finish their studies, those who were out of the labor force but decide to rejoin the labor force, they constitute the inflow of the unemployed population. These inflows increase the unemployment rate given the labor force. The outflows include the ones who secure new jobs as well as those who stop looking for jobs. The increase in outflows given labor force (labor force will change too if discouraged workers stop looking for jobs) will decrease the unemployment

Labor Economics as per the Neo-Classical approach

The labor markets are assumed to work like the other markets (such as the goods market, money market etc.) in the economy as per Neo-Classical economists. However, there are a few differences between labor market and other types of markets that must be kept in mind.

Firstly, supply in most markets is unlimited to some extent at least in the long run, more and more can be produced by employing more resources in the production of the required good or service. However, the supply of labor is limited because there is only a limited amount of time every day. Thus, the demand of labor can only be satisfied up to the extent of time available to each individual for labor. Also, unlike other markets the labor markets will can be non-clearing, this is evident from the fact that there is persisting unemployment in most countries.

The equilibrium is determined at the intersection of labor demand and labor supply curve. The labor supply curve is determined by the labor decisions made by households that is, suppliers of labor. The labor supply curve is determined on the basis of utility maximization by individuals based on constraints of time and income. The labor supply curve is often a backward bending curve. The reason for the unusual shape of the labor supply curve lies in the concept of income and substitution effects. At low levels of wages, when wages increase the substitution effect of this change (leisure is more expensive now) exceeds the income effect of the change (since income is higher you wish to consume more of leisure). However, at high level of wages, the income effect dominates the substitution effect. As a result we obtain a backward bending labor supply curve.

The Labor Demand Curve is the value of marginal product of labor curve faced by the individual firms. Value of marginal product is the marginal productivity (contribution of additional unit of labor to the total product) times the price of the good being produced.

What are the drawbacks of this model?

This model is criticized because the assumption of perfect competition rarely holds in the real economic world. As with most other markets, perfect competition is rarely seen in labor markets. In an industry with just one firm a monopsony is created in the labor market. This is an extreme case but nevertheless forms of competition other than perfect competition are more prevalent in labor markets.

Productivity varies from worker to worker and mostly the employers cannot differentiate between the hard workers and those who deliberately put in less effort. This increases the incentive to reduce effort as the employer is unable to identify the non-hard workers from the hard workers. As a result the overall productivity of the labor falls. In recent times, stock options have been introduce to solve this problem. Providing stock options motivates the workers to work hard as they reap benefits not just from wages but from dividend as well.

Another problem faced by the employers in the labor market is the problem of adverse selection. If the skills of the worker varies and the employer has no means to identify the abilities, he will be willing to pay only an average of wages of these workers. But at this wage the high skilled workers do not wish to work and by the problem of adverse selection the employer ends up hiring only low-ability workers. This problem can be solved to some extent by signaling. High ability workers may acquire higher educational qualifications so that employers are able to tell them apart from the others. Thus, workers may wish to acquire such educational qualifications even if it does not increase productivity, just as a signaling mechanism for the employer.